Faith in renewed growth is an ill-advised policy

PRINCETON, NEW JERSEY – In a provocative recent paper, Robert Gordon of Northwestern University concludes that the rate of technological progress has slowed sharply, and that the rise in standards of living (at least in the world’s rich countries) is thus set to decelerate. In the 20th century, he says, per capita income in the United States doubled about every 25 to 30 years. But the next doubling will likely occur only over 100 years, a pace last seen in the 19th century.

Long-term growth considerations, while recognized as crucial, seem distant from the here and now of financial repair and restoration of confidence. So the commentary on Gordon’s paper has been largely dissociated from the policy discussions addressing the ongoing Great Recession.

But a realistic assessment of growth prospects is precisely what is needed right now to design appropriate and feasible policies. Gordon’s point is not that growth will decelerate in the future, but rather that underlying productivity growth moved to a sharply lower trajectory around 2000.

We lived the better part of the subsequent decade with a misguided sense of extended prosperity and inflated a financial bubble. Worse, we are treating the present as if the bubbly growth from 2000 to 2007 will return.

Consider the International Monetary Fund’s regular projections of world growth. In April 2010, about 18 months after the Lehman Brothers meltdown, the crisis seemed over. The forecast was for world GDP to grow at about 4.5 percent annually until 2015, which is slightly higher than the pace during the pre-crisis decade, while the average annual inflation rate was projected to be lower, at 2.9 percent. The future looked bright. Instead, after successive revisions, world GDP in 2012 is now expected to grow by only 3.3 percent while inflation is forecast to reach 4 percent, signaling much weaker global economic momentum than was anticipated.

Lower-than-expected growth and higher-than-expected inflation have affected most economies. In 2011 and 2012, the United Kingdom stood out among the advanced economies in this regard; but the pattern holds even for Germany. The shine has similarly worn off the BRICs (Brazil, Russia, India and China).

Although projections by the IMF and others have been persistently optimistic, each setback has been treated as a temporary deviation, associated with its own unique cause: the Greek bailout, the tragic tsunami in Japan, the spike in volatility following Standard & Poor’s downgrade of U.S. debt, and so on. The return to 4.5 percent world growth has merely been pushed back — in the latest forecasts to 2015.

Faith in renewed growth is an ill-advised policy strategy. At its core, the global economic crisis is a growth crisis. Financial institutions and markets assumed productivity would continue to grow at the pace of the late 1990s, which fostered an asset-price boom that conveyed an illusion of well-being; those not directly involved in the financial bubble were coopted through buoyant international trade. European growth, with its heavy dependence on trade, received a special boost, as did emerging markets.

Once the Great Recession began, this process operated in reverse, unwinding the excesses. But policymakers continued to benchmark recovery prospects to pre-crisis growth performance. When reality proved otherwise, the return of the past was not abandoned, but merely postponed. Continuing to assume the resumption of pre-crisis growth was necessary to justify postponing hard decisions.

For example, a growth rebound underpins the expectation that the European periphery will not restructure or inflate away its sovereign debt. The assumption that the German economy will accelerate out of its current crawl is essential to confidence in Europe’s financial safety net, and to a banking union that credibly shares risks across the eurozone. Resumption of robust world economic growth is the basis for delaying the implementation of the Basel III bank rules. And, if the BRICs slow down, they may be more prone to debt and currency crises.

What is to be done? Because the elixir of growth in policymakers’ forecasts cannot be counted on to solve the problems, dealing with financial excesses becomes even more urgent. That means more debt restructuring and more bank closures now, rather than watering down proposals to rein in freewheeling markets. Looking ahead, as Robert Shiller of Yale University has repeatedly emphasized, public policy must help to forge futures markets that hedge risks better and more reliably align incentives.

There is no magical path to higher productivity growth. Even if Gordon’s pessimism is excessive, the timing of the next breakthrough in technology is impossible to predict. So-called structural reforms may help, but the likely gains are small and uncertain. It may simply be time to learn how to live with less.